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1 DEPRECIATION, IMPAIRMENTS, AND DEPLETION. 2 1.Explain the concept of depreciation. 2.Identify the factors involved in the depreciation process. 3.Compare.

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Presentation on theme: "1 DEPRECIATION, IMPAIRMENTS, AND DEPLETION. 2 1.Explain the concept of depreciation. 2.Identify the factors involved in the depreciation process. 3.Compare."— Presentation transcript:

1 1 DEPRECIATION, IMPAIRMENTS, AND DEPLETION

2 2 1.Explain the concept of depreciation. 2.Identify the factors involved in the depreciation process. 3.Compare activity, straight-line, and decreasing-charge methods of depreciation. 4.Explain special depreciation methods. 5.Explain the accounting issues related to asset impairment. 6.Explain the accounting procedures for depletion of natural resources. 7.Explain how to report and analyze property, plant, equipment, and natural resources. Learning Objectives

3 3 Depreciation Factors involved Methods of depreciation Special methods Special issues ImpairmentsDepletion Presentation and Analysis Recognizing impairments Measuring Impairments Restoration of loss Assets to be disposed of Presentation Analysis Establishing a base Write-off of resource cost Estimating reserves Liquidating dividends Continuing controversy Depreciation, Impairments, and Depletion

4 4 Allocating costs of long-term assets: Fixed assets = Depreciation expense Intangibles = Amortization expense Natural resources = Depletion expense Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. Depreciation - Method of Cost Allocation LO 1 Explain the concept of depreciation.

5 5 Depreciation - Method of Cost Allocation LO 2 Identify the factors involved in the depreciation process. Three basic questions : Factors Involved in the Depreciation Process (1)What depreciable base is to be used? (2)What is the assets useful life? (3)What method of cost allocation is best?

6 6 Depreciation - Method of Cost Allocation LO 2 Identify the factors involved in the depreciation process. Depreciable Base Factors Involved in the Depreciation Process Illustration 11-1

7 7 Depreciation - Method of Cost Allocation LO 2 Identify the factors involved in the depreciation process. Estimation of Service Lifes Factors Involved in the Depreciation Process Service life of an asset often differs from its physical life. Companies retire assets for two reasons: physical factors (such as casualty or expiration of physical life) and economic factors (obsolescence).

8 8 Depreciation - Method of Cost Allocation LO 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. The profession requires the method employed be systematic and rational. Examples include: Methods of Depreciation (1)Activity method (units of use or production). (2)Straight-line method. (3)Sum-of-the-years-digits. (4)Declining-balance method. (5)Group and composite methods. (6)Hybrid or combination methods. Accelerated methods Special methods

9 9 Depreciation - Method of Cost Allocation LO 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. Activity Method Illustration 11-2 Illustration: If Stanley uses the crane for 4,000 hours the first year, the depreciation charge is: Stanley Coal Mines Facts Illustration 11-3

10 10 Depreciation - Method of Cost Allocation LO 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. Straight-Line Method Illustration 11-2 Illustration: Stanley computes depreciation as follows: Stanley Coal Mines Facts Illustration 11-4

11 11 Depreciation - Method of Cost Allocation LO 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. Decreasing-Charge Methods Illustration 11-2 Stanley Coal Mines Facts Sum-of-the-Years-Digits. Each fraction uses the sum of the years as a denominator ( = 15). The numerator is the number of years of estimated life remaining as of the beginning of the year.

12 12 Depreciation - Method of Cost Allocation LO 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. Sum-of-the-Years-Digits Illustration 11-6

13 13 Depreciation - Method of Cost Allocation LO 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. Decreasing-Charge Methods Illustration 11-2 Stanley Coal Mines Facts Declining-Balance Method. Utilizes a depreciation rate (percentage) that is some multiple of the straight-line method. Does not deduct the salvage value in computing the depreciation base.

14 14 Depreciation - Method of Cost Allocation LO 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. Declining-Balance Method Illustration 11-7

15 15 Depreciation - Method of Cost Allocation LO 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. E11-5 (Depreciation ComputationsFour Methods): KC Corporation purchased a new machine for its assembly process on August 1, The cost of this machine was $150,000. The company estimated that the machine would have a salvage value of $24,000 at the end of its service life. Its life is estimated at 5 years and its working hours are estimated at 21,000 hours. Year-end is December 31. Instructions: Compute the depreciation expense under the following methods. (a) Straight-line depreciation. (c) Sum-of-the-years-digits. (b) Activity method(d) Double-declining balance.

16 16 Depreciation - Method of Cost Allocation LO 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. Straight-line Method

17 17 Depreciation - Method of Cost Allocation LO 3 Activity Method (Assume 800 hours used in 2010)

18 18 Depreciation - Method of Cost Allocation Sum-of-the-Years-Digits Method LO 3 5/12 = /12 =

19 19 Depreciation - Method of Cost Allocation Double-Declining Balance Method LO 3

20 20 Depreciation - Method of Cost Allocation LO 4 Explain special depreciation methods. The choice of method depends on the nature of the assets involved: Special Depreciation Methods Group method used when the assets are similar in nature and have approximately the same useful lives. Composite approach used when the assets are dissimilar and have different lives. Companies are also free to develop tailor-made depreciation methods, provided the method results in the allocation of an assets cost in a systematic and rational manner (Hybrid or Combination Methods).

21 21 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

22 22 Depreciation - Method of Cost Allocation LO 4 Explain special depreciation methods. Special Depreciation Issues (1)How should companies compute depreciation for partial periods? Companies normally compute depreciation on the basis of the nearest full month. (2)Does depreciation provide for the replacement of assets? Funds for the replacement of the assets come from the revenues (3)How should companies handle revisions in depreciation rates?

23 23 Changes in Depreciation Rate Accounted for in the period of change and future periods (Change in Estimate) Not handled retrospectively Not considered errors or extraordinary items LO 4 Explain special depreciation methods. Depreciation - Method of Cost Allocation

24 24 Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2010 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Questions: What is the journal entry to correct the prior years depreciation? Calculate the depreciation expense for No Entry Required Change in Estimate Example LO 4 Explain special depreciation methods.

25 25 Equipment$510,000 Fixed Assets: Accumulated depreciation 350, ,000 Net book value (NBV) Net book value (NBV)$160,000 Balance Sheet (Dec. 31, 2009) Change in Estimate Example After 7 years Equipment cost $510,000 Salvage value - 10,000 Depreciable base500,000 Useful life (original) 10 years Annual depreciation $ 50,000 x 7 years = $350,000 First, establish NBV at date of change in estimate. LO 4 Explain special depreciation methods.

26 26 Change in Estimate Example After 7 years Net book value $160,000 Salvage value (new) 5,000 Depreciable base155,000 Useful life remaining 8 years Annual depreciation $ 19,375 Depreciation Expense calculation for Depreciation expense 19,375 Accumulated depreciation 19,375 Journal entry for 2010 LO 4 Explain special depreciation methods.

27 27 Impairments LO 5 Explain the accounting issues related to asset impairment. When the carrying amount of an asset is not recoverable, a company records a write-off referred to as an impairment. Events leading to an impairment: a.Decrease in the market value of an asset. b.Change in the manner in which an asset is used. c.Adverse change in legal factors or in the business climate. d.An accumulation of costs in excess of the amount originally expected to acquire or construct an asset. e.A projection or forecast that demonstrates continuing losses associated with an asset.

28 28 Impairments LO 5 Explain the accounting issues related to asset impairment. Measuring Impairments 1.Review events for possible impairment. 2.If the review indicates impairment, apply the recoverability test. If the sum of the expected future net cash flows from the long-lived asset is less than the carrying amount of the asset, an impairment has occurred. 3. Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market value or the present value of expected future net cash flows.

29 29 Impairments LO 5 Explain the accounting issues related to asset impairment. Illustration Accounting for Impairments

30 30 E11-16 (Impairment): Presented below is information related to equipment owned by Pujols Company at December 31, Assume that Pujols will continue to use this asset in the future. As of December 31, 2010, the equipment has a remaining useful life of 4 years. Instructions: (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, (b) Prepare the journal entry to record depreciation expense for (c) The fair value of the equipment at December 31, 2011, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value. Impairments LO 5 Explain the accounting issues related to asset impairment.

31 31 Loss on impairment 3,600,000 Accumulated depreciation 3,600,000 Impairments (a). 12/31/10 LO 5 Explain the accounting issues related to asset impairment.

32 32 Depreciation expense 1,100,000 Accumulated depreciation 1,100,000 Impairments (b). (c). (c). Restoration of any impairment loss is not permitted. 12/31/11 LO 5 Explain the accounting issues related to asset impairment.

33 33 Natural resources, often called wasting assets, include petroleum, minerals, and timber. They have two main features: Depletion LO 6 Explain the accounting procedures for depletion of natural resources. 1.complete removal (consumption) of the asset, and 2.replacement of the asset only by an act of nature. Depletion is the process of allocating the cost of natural resources.

34 34 Establishing a Depletion Base Depletion LO 6 Explain the accounting procedures for depletion of natural resources. Computation of the depletion base involves four factors: (1)Acquisition cost of the deposit, (2)Exploration costs, (3)Development costs, and (4)Restoration costs.

35 35 Write-off of Resource Cost Depletion LO 6 Explain the accounting procedures for depletion of natural resources. Normally, companies compute depletion on a units-of- production method (an activity approach). Thus, depletion is a function of the number of units extracted during the period. Calculation: Total cost – Salvage value Total estimated units available = Depletion cost per unit Units extracted x Cost per unit = Depletion

36 36 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

37 37 E11-19 (Depletion ComputationsTimber): Hernandez Timber Company owns 9,000 acres of timberland purchased in 1999 at a cost of $1,400 per acre. At the time of purchase the land without the timber was valued at $400 per acre. In 2000, Hernandez built fire lanes and roads, with a life of 30 years, at a cost of $87,000. Every year Hernandez sprays to prevent disease at a cost of $3,000 per year and spends $7,000 to maintain the fire lanes and roads. During 2001, Hernandez selectively logged and sold 700,000 board feet of timber, of the estimated 3,000,000 board feet. In 2002, Hernandez planted new seedlings to replace the trees cut at a cost of $100,000. Depletion LO 6 Explain the accounting procedures for depletion of natural resources. Instructions: Determine the depreciation expense and the cost of timber sold related to depletion for 2001.

38 38 E11-19 (Depletion ComputationsTimber) Depletion LO 6 Explain the accounting procedures for depletion of natural resources.

39 39 E11-19 (Depletion ComputationsTimber) Depletion LO 6 Explain the accounting procedures for depletion of natural resources.

40 40 Estimating Recoverable Reserves Depletion LO 6 Explain the accounting procedures for depletion of natural resources. Same as accounting for changes in estimates. Revise the depletion rate on a prospective basis. Divides the remaining cost by the new estimate of the recoverable reserves.

41 41 Liquidating Dividends - Dividends greater than the amount of accumulated net income. Depletion LO 6 Explain the accounting procedures for depletion of natural resources. Illustration: Callahan Mining had a retained earnings balance of $1,650,000 and paid-in capital in excess of par of $5,435,493. Callahans board declared a dividend of $3 a share on the 1,000,000 shares outstanding. It records the $3,000,000 cash dividend as follows. Retained Earnings 1,650,000 Paid-in Capital in Excess of Par 1,350,000 Cash 3,000,000

42 42 Continuing Controversy Oil and Gas Industry: Full cost concept Successful efforts concept Depletion LO 6 Explain the accounting procedures for depletion of natural resources.

43 43 Presentation of Property, Plant, Equipment, and Natural Resources Presentation and Analysis Basis of valuation (cost) Pledges, liens, and other commitments Depreciation expense for the period. Balances of major classes of depreciable assets. Accumulated depreciation. A description of the depreciation methods used. Depreciating assets, use Accumulated Depreciation. Depleting assets may include use of Accumulated Depletion account, or the direct reduction of asset. Disclosures LO 7 Explain how to report and analyze property, plant, equipment, and natural resources.

44 44 The assets turnover is a measure of a firms ability to generate sales from a particular investment in assets. Presentation and Analysis LO 7 Explain how to report and analyze property, plant, equipment, and natural resources. Solution on notes page Illustration 11-20

45 45 Presentation and Analysis LO 7 Explain how to report and analyze property, plant, equipment, and natural resources. The profit margin on sales is a measure of the ability to generate operating income from a particular level of sales. Solution on notes page Illustration 11-21

46 46 Presentation and Analysis LO 7 Explain how to report and analyze property, plant, equipment, and natural resources. Rate of Return on Assets measures a firms success in using assets to generate earnings. Solution on notes page Illustration 11-22

47 47 The analyst obtains further insight into the behavior of ROA by disaggregating it into components of profit margin on sales and asset turnover as follows: Net Income Average Total Assets Rate of Return on Assets = Net Income Net Sales Profit Margin on Sales = Net Sales Asset Turnover x x Average Total Assets Presentation and Analysis LO 7 Explain how to report and analyze property, plant, equipment, and natural resources.

48 48 $64.2 ($ ) / 2 Rate of Return on Assets = $64.2 $420.1 Profit Margin on Sales = $420.1 Asset Turnover x x Presentation and Analysis 8.7%15.28% =x.569 ($ ) / 2 LO 7 Explain how to report and analyze property, plant, equipment, and natural resources. The analyst obtains further insight into the behavior of ROA by disaggregating it into components of profit margin on sales and asset turnover as follows:

49 49 Under both iGAAP and U.S. GAAP, interest costs incurred during construction must be capitalized. iGAAP, like U.S. GAAP, capitalizes all direct costs in self- constructed assets. The accounting for exchanges of nonmonetary assets has recently converged between iGAAP and U.S. GAAP. iGAAP permits the same depreciation methods (straight-line, accelerated, units-of-production) as U.S. GAAP.

50 50 As discussed in the Chapter 4 Convergence Corner, iGAAP permits asset revaluations (which are not permitted in U.S. GAAP). Consequently, companies that use the revaluation framework must follow revaluation depreciation procedures. iGAAP also uses a fair value test to measure the impairment loss. However, iGAAP does not use the first-stage recoverability test used under U.S. GAAPcomparing the undiscounted cash flows to the carrying amount. Thus, the iGAAP test is more strict than U.S. GAAP.

51 51 LO 8 Describe income tax methods of depreciation. Modified Accelerated Cost Recovery System MACRS differs from GAAP in three respects: 1.a mandated tax life, which is generally shorter than the economic life; 2.cost recovery on an accelerated basis; and 3.an assigned salvage value of zero.

52 52 LO 8 Describe income tax methods of depreciation. Modified Accelerated Cost Recovery System Tax Lives (Recovery Periods) Illustration 11A-1

53 53 LO 8 Describe income tax methods of depreciation. Modified Accelerated Cost Recovery System Tax Depreciation Methods Illustration 11A-2

54 54 LO 8 Describe income tax methods of depreciation. Modified Accelerated Cost Recovery System Illustration: Computer and peripheral equipment purchased by Denise Rode Company on January 1, 2009.

55 55 LO 8 Describe income tax methods of depreciation. Modified Accelerated Cost Recovery System Illustration: Illustration 11A-3

56 56 LO 8 Describe income tax methods of depreciation. Modified Accelerated Cost Recovery System Illustration: Using the rates from the MACRS depreciation rate schedule for a 5-year class of property, Rode computes depreciation as follows Illustration 11A-4 Illustration 11A-5

57 57 LO 8 Describe income tax methods of depreciation. Modified Accelerated Cost Recovery System Additional Issues Optional straight-line method Tax versus book depreciation

58 58 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

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